5/06/2009 @ 12:00AM

Are There Any Rules In The Bailout Game?

We are entering a precarious phase of the economic and financial crisis. On the one hand, there are encouraging, if weak, signs of an economic recovery. There is evidence of a revival in lending. Consumer confidence is improving quite a bit both in the U.S. and Europe.

But on the other hand, lots of things are not happening. Many investors are sitting on the sidelines, as is much money. Why? Because it is impossible to know what the rules of the game are. And that’s because the administration and the Congress keep changing the rules in capricious ways in pursuit of larger political objectives.

Government interference in the normal conduct of business has had a chilling effect on financial markets and threatens the progress of the recovery. The Treasury and the Fed have created many new programs to provide liquidity to the financial system, to help banks restructure their balance sheets and to re-invigorate securitization markets.

So far, the interest in these has been distinctly muted because potential participants fear the longer term consequences of getting involved with any of these programs.

The Term Asset-Backed Lending Facility (TALF) is a good example. It was designed to stimulate an important part of the credit market–based on securitized loans–by providing a facility to lend up to $1 trillion in loans to buyers of top-rated securities that are collateralized by credit-card debt, auto loans, student loans, small business loans and commercial real estate loans.

Because they are non-recourse loans, the investors have little downside exposure. But so far, they have stayed away. They are afraid of the strings that may be attached, since the loans are ultimately secured by TARP funds.

Elizabeth Warren’s Congressional Oversight Panel has already been dogging the Fed and the Treasury about TALF. That’s certainly not going to encourage investment.

These concerns also don’t bode well for the success of the Public-Private Investment Partnership (PPIP)–the program designed to take “legacy” assets off the balance sheets of banks and thus aid their recovery. It, too, relies on TARP funds as well as guarantees provided through the FDIC.

Investors, other than the banks who desperately needed TARP funds for survival, are leery of any program that uses them. Anyone who took TARP funds has been subject to government interference in managerial decisions. The restrictions on bonuses and executive pay have been widely discussed in the media. Less well known are restrictions on the banks’ ability to hire foreigners, and the constant harassment by Congress over internal management decisions on everything from the use of private aircraft to the locations of conferences. Some of these concerns are well justified, of course, but it wasn’t clear ex-ante what all of the rules were and it isn’t clear ex-post either.

Goldman Sachs, JPMorgan Chase and a number of other banks want to repay their government TARP loans in order to get the government off their back. Now there is an argument afloat that they shouldn’t be allowed to pay back funds if they took advantage of the Temporary Liquidity Guarantee Program (TLGP).

This was an incredible ill-conceived program that Treasury and the FDIC put in place in a panic. It allowed participants to issue guaranteed debt for a fee of 75 basis points regardless of their financial condition. The banks were offered a free lunch and now may be punished for having eaten it.

The Obama administration has shown repeatedly that it is willing to change the rules and even challenge the sanctity of contracts in the interests of its political agenda. The best, most recent example is the Chrysler restructuring.

The administration decided to tilt the restructuring in favor of the unions. The government proposed giving the United Auto Workers’ retiree health fund a 55% equity stake in Chrysler–more than the combined stakes of Chrysler’s merger partner, Fiat, or the other secured creditors that are owed roughly $7 billion. When some of the secured creditors, who were offered 30 cents on the dollar, balked, they were attacked by Obama as speculators.

Because of the holdout, Chrysler filed for Chapter 11 last week, and GM will soon follow. One might hope that, in bankruptcy, the well-known rules of the game, not political favoritism, would rule the day. Chrysler’s dissident lenders have on their side the “absolute priority” bankruptcy rule, which holds that value must be distributed according to the legal priorities of the stakeholders.

Unfortunately, the bankruptcy code also holds that the absolute priority rule can be modified if a two-thirds majority can convince the court that it makes legal or business sense. Two-thirds of the lenders can force the holdouts to go along with them in a procedure called a cram-down.

That is exactly what is likely to happen. Citi, JP Morgan Chase, Goldman Sachs and Morgan Stanley, all major recipients of TARP Funds, all deep in the pocket of the Treasury, agreed to the administration’s plan. So it looks like bankruptcy law will take a back seat to social policy.

There is at least some poetic justice in this outcome. The unions, whose years of work rules, and pension and health care deals helped sink the company, will have to eat their own cooking from now on. But their future success needs not only labor but capital.

Why would private capital get involved when the rules of the game are so capricious? No one would take that gamble when it is clear that, in dealing with the government, private capital will always take a back seat to politically powerful entities.

And that is the larger worry that current policy has neglected. Firms and markets can function quite well within a framework of rules. Indeed, rules are good for the orderly conduct of business. But when rules get imposed or dispensed with willy-nilly in the interests of politics, it is very dangerous. We have should have learned this lesson long ago.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes.